Personal Finance

When You Should (And Shouldn’t) Co-Sign a Loan

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Helping a family member or friend to secure a loan is a nice gesture. Co-signing a loan is very common, but not without its pitfalls. A poll by CreditCards.com found that 1 in 6 respondents had co-signed for someone else, whether to get a credit card or other type of loan. However, is it really a good idea to co-sign a loan application? While there’s no question that it feels nice to help someone in need, there is still a significant amount of risk involved. If the loan isn’t repaid on time, you could be on the hook for the amount borrowed – plus interest and penalty fees.

That same poll found that 38% of co-signers ended up paying some (or all) of the loan or credit card. That’s what happens if the primary borrower defaults on the payments. Dollars and cents aside, once you enter into a financial transaction with someone close to you, it inevitably changes the relationship. It’s not always for the better, either. Here are things to consider if you’ve been asked to co-sign for someone.

Consider Who is Asking

The first thing you should do is think about the person asking for your help. How well do you know them? Are they family member, close friend, or just a casual acquaintance? Have they asked you for financial help before? If yes, how did it turn out? Are they consistently employed? Are they someone who consistently lives beyond their means? In short, are they actually capable of making payments on this loan they aren’t able to qualify for on their own?

If you co-sign their loan, you are vouching for them. So perhaps the most important question is this: Is the person trustworthy? Scrutinizing the person asking for help is the first step in analyzing whether co-signing for a loan would be a good decision or not.

What is the Purpose of the Loan?

The next thing to consider is the purpose of the loan. Is the money for a “want” or a “need?” Making this distinction is important. Are they using money to buy a much-needed new car, in order to commute to their job? Or are they merely wanting a lavish vacation (that they probably can’t afford)? Will the loan be used for an investment, like a college education or a mortgage? These answers will help guide you.

You should also consider whether there have been extenuating circumstances. People do get genuinely unlucky all the time, and suffer from a surprise job less, health issue, or other unavoidable financial crisis. If you can determine that they need you to co-sign as a result of bad luck (as opposed to poor money management), it can influence your decision.

Pay Attention to Red Flags

When it comes to loans involving family and friends, there are often red flags visible for people who choose to see them. Many people who turn to relatives or friends for help in securing a loan do so because they are unable to get a traditional loan from a bank on their own. This is often because they have a poor credit score, a history of loan delinquencies and are referred to by financial professionals as “habitual offenders,” people who borrow money and run into trouble with repaying a loan.

Some red flags to be aware of include a history of failed investments, business ventures or other schemes. Another red flag is if the person has borrowed small sums of money in the past and is now looking to borrow larger amounts. Remember that past behaviour is usually a predictor of future conduct. It is always advisable to request a credit check on people and find out their current debt levels and credit score before you agree to be a co-signer on a loan for them.

Weigh the Financial Risks

Being a co-signer on a loan comes with substantial risks. If the person taking out the loan defaults on their obligations, you, as the co-signer, could see your credit score damaged. You could also be subject to legal actions from lenders. You could even have your wages at work garnished to repay the loan. Additionally, your own ability to borrow money and qualify for loans could be damaged. That will make it harder for you to get any sort of new credit when you need it.

Remember that, as a co-signer, you are 100% responsible to repay a loan if the principle signer doesn’t repay it themselves. You’re not just lending them your good credit score. You’re promising to pay if they don’t. It won’t matter they they defaulted – a job loss, disability, or even death won’t get you out of it. If your name is attached, lenders can (and will) come after you for repayment.

Assess Your Own Finances

Another essential question that you should before co-signing a loan is a simple one. “Can I afford to help?” The answer will require you to scrutinize your own finances. This is especially true if you’re close to retiring or are living on a fixed income. You need to carefully consider the impact that a potential loan default could have on your financial situation. If things go south, it will seriously affect your ability to live comfortably and maintain your standard of living. This is especially true if the loan is for a large amount, like a home mortgage. You should also know student loans that cannot be written off with a bankruptcy filing. That makes them an extra tricky ask.

Can You Afford to Repay the Loan Yourself?

You need to consider whether you can afford to repay the loan yourself, should it come to that. Hopefully it wont. However, if you were forced to repay the debt yourself, would you still be alright financially? Loans that involve some form of collateral, such as a house or vehicle, are generally safer than loans made for less tangible items. If a mortgage defaults, the bank can always reclaim the house and sell it. The same cannot be said for a failed business venture or  lavish vacation. Be sure to factor your own financial situation into the equation. The bottom line is that if you can’t do without the money, you shouldn’t co-sign. You’ll only be putting yourself in harms way.

Read the Fine Print

Before you put your signature on any loan document, it’s critically important that you read the fine print. Do you fully understand the contract that you are entering into? When is the loan due? What is the repayment schedule? How much interest is being charged on the loan? What are the penalties and fees in the event that a payment is late or defaulted on? What recourse, if any, would you have to contest the loan if you are called on to repay it? Knowing and understanding the terms of the loan is essential for any co-signer. It’s the best way to know exactly what you’re getting into.

Protect the Personal Relationship

Lastly, take steps to protect the personal relationship you have with a loved one or friend should you enter into a loan arrangement together. Don’t let money cause irreparable harm to a valued relationship. By setting clear expectations and giving full consideration to the person you are co-signing for, you can retain a strong and positive relationship. Fights over money have ruined plenty a relationship throughout history. Don’t let it happen to you. Most importantly, have the courage to say “no” if you need to. Yes, even to a relative or close friend. The biggest risk is the loss of a relationship, not the loss of money.

The Last Word

Co-signing for a loan isn’t always a disaster. Many parents co-sign for their children when they are buying their first car or house, or applying for their first credit card. Later in life, those children may co-sign something for an elderly parent who no longer has a consistent income. While it’s important to take care of the people you love, it’s also important to not make any stupid financial decisions.

Always remember that co-signing is literally the same as applying for the credit or loan yourself. It will appear on your credit report. It could even lower your score temporarily. And ultimately, you will be responsible to pay any debts associated with it if the principle borrower stops paying themselves. If you’ve asked yourself all the relevant questions and are satisfied with the answers, go ahead on co-sign. If a bunch of red flags pop up instead, you should probably think twice.

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